1. Field of the Invention
This invention relates generally to management of tax-deferred retirement accounts, and more particularly to a system and method of managing tax-deferred retirement accounts that enables the participants to invest in exchange traded funds (ETFs) and to forecast and intelligently plan for their retirement savings needs.
2. Description of the Related Art
Policy-makers and researchers have an acute interest in the growth of pension plans and their relationship in influencing work and retirement, saving and consumption, and well-being in old age. Analysts concerned about poverty and income sufficiency acknowledge that pensions play a key role in the well-being of the elderly. Traditional pension plans, such as defined benefit plans that promised each employee a certain amount of his or her salary at retirement, placed responsibility for retirement planning for each employee on the employer, making the employer a “fiduciary.” However, over the past several years, there has been a shift from defined benefit plans to self-directed defined contribution plans, such as 401(k) plans. Consequently, with the proliferation of 401(k) plans, responsibility for retirement planning has shifted away from the employer and now rests squarely on the shoulders of each individual plan participant. By and large, the plan participants are not well equipped to handle such responsibility.
In 1995, researcher John Shoven confirmed that pension assets grew faster than total wealth in the United States during the 1980's, leading Shoven to conclude that “pensions are how America saves.” At the same time that pension wealth has grown, there has been a revolution in the pension industry, as defined contribution plans, and 401(k) plans in particular, have become the pension plans of choice. Defined contribution plans increased from 13 to 30 percent between 1975 and 1985 and then to 42 percent in 1992. By 1997, defined contribution plans rose to 53 percent. See Defined Contribution Plan Dominance Grows Across Sectors . . . , special report by Kelly Olsen and Jack Van Derhei, Employee Benefit Research Institute, October 1997, Special Report 190, Washington, D.C. By projecting trends on pension contributions, the U.S. Department of Labor in 1997 concluded that more money is going into private 401(k) plans than all other private pension plans combined. Most of the contributions are coming directly from workers.
At the same time, there was a similar shift in the responsibility for managing assets in employer-sponsored retirement plans. Previously, the Chief Investment Officers and Chief Financial Officers of employer companies acted not only as the trustee for the plan but also as the investment officer for the plan. However, with the shift to defined contribution plans, the overwhelming majority of workers participating in 401(k) plans are required to manage the investment of their retirement savings directly. In this brave new world, workers not only have to determine when to start saving for retirement and how much to contribute to their retirement accounts, they also must decide how to allocate their retirement funds across various types of assets.
Unfortunately, as illustrated by a Watson Wyatt study, participant directed 401(k) plans are lagging behind institutional investors' returns in defined benefit plans by two percent (2%) annually. At first blush, a two percent (2%) difference may appear insignificant; however, the difference over a thirty-year period is staggering. For workers, a thirty-year period represents the average time horizon between mid-career and mid-retirement. Over a period of thirty years, $100,000 invested at ten percent (10%) will earn $1,744,940, while the same $100,000 invested at eight percent (8%) will earn only $1,006,266. In this example, the missing two percent compounds to nearly three-quarters of a million missing dollars.
As reported by The Profit Sharing/401(k) Council of America, by the end of 2003 there were over 42 million 401(k) plan participants with $1.9 Trillion invested. With the proliferation of participant-directed 401(k) plans, more employees are directing the investment of their pension plan assets, despite the fact that most of them do not feel up to the task as evidenced by a number of surveys. The surveys reveal that most participants do not have a sufficient understanding of investment concepts and principles in order to make their own, well-informed investment decisions. For example, in a 1996 survey by Merrill Lynch, 53% of employees said that their employers do not provide sufficient investment related materials; 80% said that educational materials or assistance would help them make better decisions; and 66% said that estimating the amount needed to be saved for retirement was the least covered topic. Similarly, in a Watson Wyatt survey of 622 companies, 66% of the employees rated printed information as not effective, 58% said that their plan does not project future account balances, and 90% said that their employers were not effective in communication. Clearly, 401(k) participants do understand that they are not prepared to make basic investment decisions which are necessary in order for them to achieve their retirement goals. Faced with overwhelming doubt, participants often turn to coworkers, friends, and the anecdotal information they read in newspaper and magazine articles for guidance in making their investment decisions. In 1996, Dalbar Financial Services reported that 83% of the respondents expect their employers to provide them with “investment education.” The September 1997 issue of Pension and Investments confirms this trend: “Participant demand for investment education and information grows . . . . ” Participants are requesting help from their employers. Unfortunately, today's typical 401(k) plan service provider simply directs a participant's attention to numerous mutual funds, focusing on “past performance” rather than concentrating on the retirement goal of each plan participant. The consequence of the “performance disease” is low returns, high costs, and inattention to the risks and rewards of asset allocation.
Currently 401(k) service providers have no real solution for helping participants meet their retirement goals. Firms such as Financial Engines, Clear Choice, and Plan Tools, who are third party Registered Investment Advisory firms, offer online investment advice through generic risk/reward scenarios after the participant completes a risk/reward questionnaire. Based on the results of the questionnaire indicating the participant's risk tolerance, a portfolio of funds is recommended. However, using this methodology, a portfolio is recommended which may not meet the actual retirement needs of the participant. Furthermore, in the case of Financial Engines, the recommended portfolio only illustrates the highest probability that the participant will achieve his or her retirement goal.
Another alternative currently available to participants is to choose an asset allocation model based solely on the participant's age. This alternative is offered by several mutual fund companies. Lifestyle funds are designed under the assumption that every participant of the same age should have the same investment options, regardless of current financial status or future income needs. Lifestyle funds have proven to be an expensive investment choice since mutual fund families add an additional management fee on top of the other management fees and costs of the underlying funds.
The services offered by such firms as Financial Engines, Clear Choice, and Plan Tools are additional services that are not required to manage and administer a 401(k) plan. Consequently, those firms add additional costs to each plan participant. Furthermore, those firms do not participate in the selection process for choosing appropriate investment vehicles for the plan. Consequently, those firms are not facilitating the plan sponsor or the participants in choosing appropriate investment options for the plan. This deficiency completely precludes their ability to recommend a well-structured asset allocation model.
Lifestyle funds are funds of funds created by mutual fund families. Participants usually are allowed to select one or more lifestyle funds based on their planned retirement date or using their current age. That is, as the participant moves closer to retirement age, the portfolio mix continues to increase in bonds and decrease in equities. According to a study conducted by Hewitt Associates, participants don't even understand the principle behind lifestyle funds and end up choosing several lifestyle funds for a portfolio mix. According to that study, most of the participants were not matching their risk profile with their age in order to choose a lifestyle fund. “Many participants who used lifestyle funds weren't choosing one lifestyle fund, but allocating to several lifestyle funds at once,” said Lori Lucas, a defined contribution consultant with Hewitt Associates. “Clearly, lifestyle funds are not being used as the simple, straightforward investment solution they are intended to be.”
According to a research study conducted by HeWitt, nearly a third (30%) of plans offered a lifestyle option in 1999. Peter Lynch, former manager of the Fidelity Magellan Fund, disputes the theory that a person's age should dictate the person's investment portfolio. In his book, Beating the Street, Lynch stated that “this popular prescription, stocks for the young, bonds for the old, is . . . obsolete.”
Another major shortcoming of lifestyle funds is the fact that lifestyle funds only rely on two of the five asset classes; i.e., stocks and bonds. To compound this shortcoming, in the stock class, the majority of lifestyle funds use 100 percent large cap stocks and in the bond class, the majority of lifestyle funds use 100 percent long-term bonds.
Another major problem with current 401(k) plans involves the high investment costs and expenses which participants are paying for their mutual fund investment options. The 401k Provider Directory Averages Book “found that investment expenses account for upwards of 81% of total plan costs in smaller plans and 98% in larger plans.” Seventy-one percent (71%) of all assets in defined contribution plans are mutual funds, which carry high management fees. See Brief of US Retirement Assets 2003, Investment Company Institute, June 2004. Unfortunately, high fees and expenses result in lower retirement income for plan participants.
Exchange traded funds have much lower fees and expenses than mutual funds. However, to date, exchange traded funds have been available only through self-directed brokerage accounts or collective trusts. Unfortunately, the commission costs associated with trading ETFs through a self-directed brokerage account makes it prohibitive for 401(k) participants who invest in incremental amounts each pay period. Similarly, plan sponsors who may wish to offer ETFs to their plan participants through a collective trust are finding that the annual administrative costs, per collective trust, average $5,000 plus, which makes collective trusts prohibitive. Therefore, the costs associated with self-directed brokerage accounts and collective trusts negate any benefit participants might have enjoyed through those investment vehicles.
Accordingly, it would be a significant advancement in the art to provide a system and method of managing tax deferred retirement accounts that enable the participants to realize the reduced costs of exchange traded funds and to forecast and intelligently plan for their retirement savings needs.